Economic Quarterly

2006

Fall 2006

Stark Optimal Fiscal Policies and Sovereign Lending

It is often argued that taxing capital is inefficient in the long run. However, this policy prescription typically arises in settings where optimal policies are extreme at shorter horizons, initially involving the confiscation of assets for a period of time and setting capital income tax rates to zero, thereafter. This article points out that government lending to households, which is seldom observed in practice, plays a key role in generating the stark character of optimal fiscal policies described in much of the literature. Absent sovereign lending, more moderate capital and labor tax rates emerge as optimal, although the capital tax rate does converge to zero asymptotically. This observation suggests further consideration of the role of institutional or agency constraints that prevent the government from confiscating capital income, as well as frictions that limit sovereign lending in practice.